Remuneration: Wrong incentives, wrong result?

To be honest, I rarely pay much attention to executive remuneration. I know it’s been garnering a lot of attention lately, but the topic is just so darn boring. As a company analyst, I’ve precious little interest in wading through the minutiae of remuneration reports. I’m sure companies make their reports deliberately complex to confuse shareholders.

Still, there are two aspects of executive remuneration that get my goat. The first source of irritation is companies that change the remuneration goalposts.

Take Wesfarmers. In 2008 the company set a hurdle of a return on equity (ROE) of 12.5% before managing director Richard Goyder would be entitled to his bonus shares. Thanks to Goyder’s acquisition of Coles Group with too much debt, and the capital raisings that were subsequently required, Wesfarmers’ ROE in 2011 ended up at just 7.7%.

The 12.5% target is now virtually impossible to meet. Despite this being a direct result of Goyder’s decision to acquire Coles, the board changed the hurdle in 2011 (and shareholders unfortunately ratified it). Wesfarmers has indeed taken another step along the path to mediocrity (see Every reason for concern at Wesfarmers from 13 Nov 09 (Hold – $28.02)).

[By the way, if you want to see a totally bogus chart, head to page 73 of the Wesfarmers 2011 annual report].

Inappropriate incentives

The second annoyance is inappropriate incentives. I’ll use Sonic Healthcare’s 2011 remuneration report as the example here (a review of the company will be published on Intelligent Investor next week). My main issue is with using EBITDA (earnings before interest, tax, depreciation and amortisation) growth as one of the performance criteria for the short-term incentive part of the plan.
Chairman Peter Campbell contended that EBITDA growth is a ‘clearer measure of operational performance than net profit or earnings per share’. I dispute this, and see problems with remunerating management based on EBITDA growth.

The problem with using EBITDA is that it doesn’t recognise the cost of capital. In other words, the incentive exists for management to use debt or equity capital to grow EBITDA. It encourages management to make acquisitions or spend money on capital expenditure because these actions directly increase EBITDA.

The cost of these investments—higher interest charges or shares on issue—only shows up in earnings per share growth (or lack thereof). Billabong International is a good example—management has been encouraging shareholders to focus on EBITDA growth rather than net profit growth in 2012. The reason is that net profit is under pressure from higher interest and depreciation charges due to a string of acquisitions. These debt-funded acquisitions have potentially placed Billabong in a financially precarious position.

Sonic’s management would no doubt argue that the long-term incentive, which uses total shareholder returns and return on invested capital, offsets using EBITDA growth for the short-term incentive. Any poor use of capital should eventually show up in the long-term returns.

Thanks, and goodbye

But note the use of the word ‘eventually’. The issue is that problems from acquisitions, excessive debt or poor capital investment can take years to manifest themselves. By then, management has banked all the short-term incentives from EBITDA growth and can leave the company enriched.

I have a lot of respect for Sonic’s senior management. Chief executive Colin Goldschmidt and chief financial officer Chris Wilks have done an excellent job for many years, and I’ve no reason to think they’re anything other than shareholder-friendly.

But they’ve both been with Sonic for a long time, and retirement can’t be far from their minds. In my view, the new remuneration arrangements favour boosting short-term performance—while Goldschmidt and Wilks are still with the company—at the potential expense of long-term performance.

In general, Sonic’s remuneration report isn’t ‘bad’, and there are certainly worse ones around. But the incentives behind rewarding EBITDA growth are all wrong, particularly when there’s no guarantee the same management will be running the company in five years.

Disclosure: The author, James Greenhalgh, owns shares in Sonic Healthcare.

What do you think? Have you noticed any other remuneration reports with skewed incentives? How important is this issue?

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